Probate & Property Magazine: November/December 2008, Vol. 22, No. 5

Real Property

S. Michael Brooks is counsel to the Toronto, Canada, law firm of Aird & Berlis LLP and chief executive officer of the Real Property Association of Canada (www.realpac.ca).

A more detailed article on green leases by the author was published as part of Conference Proceedings for the Green Real Estate Summit (Mar. 5, 2008) by the Practising Law Institute, 810 7th Avenue, New York, NY 10019 (contact bschwartz@pli.edu).

Leases are long-lived agreements. Terms of 5, 10, or even 20 years are not uncommon for office, retail, and industrial premises. Therefore, the commercial leasing market must act quickly to respond to the recent critical awareness of global warming and local environmental degradation. Commercial leases must be modified now if these leases are to be flexible enough to accommodate the emergence of regional and global targets for reductions in the production of greenhouse gases and the consumption of other resources. Both landlords and tenants need to be involved in achieving these goals.

The variety of net and gross lease structures throughout North America means that of the landlord and tenant each sometimes has all or most of the economic incentive to cooperate or conserve and that each sometimes has little or no incentive to cooperate or conserve. Lawyers need to ensure that leases are structured to create compulsion, incentive, and flexibility for both parties to do the right thing. If commercial landlords wait until all levels of government agree on greenhouse gas or water use reduction standards to modify their leases, they must wait another 5, 10, or 20 years before their commercial contracts are up for renewal to implement change. This article discusses the background for, need for, benefits of, contents of, and approaches to green leases.

The Environmental Background

Commercial buildings are significant consumers of energy, the production of which creates greenhouse gases, the primary contributor to global warming. In North America, energy consumption by commercial buildings represents between 10% and 20% of all energy consumption. See U.S. Dep't of Energy, 2007 Buildings Energy Data Book table 1.1.3 (2007), available at www.btscore databook.net/docs/2007-bedb-0921.pdf (commercial buildings accounted for 18% of U.S. primary energy consumption in 2005). The energy consumption may be of natural gas for heating or of electricity for heating, running electrical systems, and/or cooling.

Commercial buildings also account for up to 20% of annual U.S. drinking water consumption. See U.S. Geological Survey, Estimated Use of Water in the United States in 1995, available at http://water.usgs.gov/watuse/pdf1995/html/ (commercial users accounted for approximately 17% of public supply withdrawals in 1995). Water is rapidly becoming a scarce resource in many parts of North America. North Americans are the highest per capita users of freshwater in the world and, in many applications, fresh treated water is misused. Residential users are often encouraged to take shorter showers, water lawns less frequently, and use reduced-water toilets and low-flow shower heads. But what is the commercial real estate sector doing to reduce its consumption of water resources?

In commercial buildings, up to 50% of the water consumption is attributable to water-cooled chillers, approximately 35% is for domestic use (for example, flushing toilets), but only about 5% is actually consumed by the occupants. The fact that the Leadership in Energy and Environmental Design (LEED) rating system and others address water conservation is a key indicator of the need for landlords to be increasingly conscious of water conservation in new building design and existing building management. Water needs to be managed just as carefully as energy.

Similarly, too much solid waste is produced from premises turnover and tenant operations, and most of it is still going to landfills. Commercial leases can address this issue as well.

What's Wrong withMy Current Lease?

Although most commercial leases are drafted with clauses of general application, most cannot accommodate new "green" issues. For example, current commercial net leases generally do not set out any shared or unilateral environmental objectives. These objectives are important links to permitted tenant and landlord conduct.

Many leases contemplate the unilateral installation of smart meters for electricity, but most do not contemplate similar smart metering for water and natural gas. Few leases contemplate limiting waste production by the tenant, either in initial fit-out or in ongoing operations. Most leases do not obligate the landlord to recycle with multiple waste streams. They generally do not require the use of environmentally friendly carpet cleaning products by the tenant and generally do not allow the landlord to purchase "green power" and pass the costs on to the tenant.

It is also uncommon, but increasingly important, for leases to address emerging green building standards. Most leases do not match a "repair and maintenance" obligation to an environmental standard; normally these are only matched to a base building, prudent tenant, or comparable building standard. Most current leases do not reconcile the targeted building maintenance standard (for example, "first class office building") to an emerging green standard (for example, "LEED EB or equivalent standard"). Commercial leases generally do not match tenant improvement standards to LEED CI or equivalent standards. For example, most leases require a tenant to use only new materials in initial fit-out or alterations, but a green lease would allow recycled materials within a tenant's premises. Similarly, most leases do not speak at all to the types of materials used within a tenant's premises, whereas a green lease would mandate that low volatile organic compound materials be used exclusively. Although many commercial leases allow a landlord to undertake energy-saving retrofits as a permitted capital cost rechargeable to the tenant, few would allow the capital and operating costs associated with the landlord retrofits necessary to improve the environmental performance of the building, comply with government sustainability "guidelines," or achieve a standard (such as LEED EB) to be an operating cost pass-through.

Most commercial leases are completely silent on the treatment of carbon credits, carbon taxes, or carbon anything. A green lease may allow the allocation of carbon credits by the landlord if the building can generate them in the future. Few current leases allow landlord access to the leased premises, except in the case of emergency or to inspect building systems on notice. A green lease would allow the landlord to enter the premises to test for environmental compliance or to determine a breach of environmental objectives.

The Role of a Green Lease

Most retail, office, and industrial premises are leased to third-party tenants and are not owner occupied. The form of third-party leases varies greatly because of both type of use and the particular landlord, who may use its own "proprietary" lease form, developed over many years of tinkering, legal review, and copying. Commercial lease forms are also available from stationers and on the Internet. Landlords may not only have a preferred overall standard form of lease, but they may also use different forms on a building-by-building basis, based on the building standard, some of them possibly inherited from a prior owner. Accordingly, the current commercial lease landscape comprises a wide variety of lease types, each reflecting the diverse nature of land use types, individual landlord and tenant preferences, and building history.

The commercial lease, in its fullest sense, governs the relationship between the landlord and the tenant: who can do what, when, and how; and who pays. It gives exclusive possession of the premises in return for rent and compliance with certain rules. In the office context, the landlord may control the shell, common areas of the building, and operations, but it is the tenant that controls activities within its own space. Both will usually have "standards" governing their conduct. Landlords may have to run a "first class office building," or act as a "prudent landlord would, having regard to the age and character of the building." (This language is typical in leases to set standards that may apply to cleaning, mechanical systems, building amenities, services, or maintenance obligations.) These standards, and other more specific provisions in a commercial lease, generally do not encourage, allow, or fairly allocate the costs of reduced energy use, reduced water use, reduced materials use, or the diversion of waste or recyclables.

Some cities, such as Seattle, have transitioned over the years from the gross lease to the net lease. Regardless of lease format, however, tenants in 50% of the nation's office buildings do not have energy costs included in their base rent according to CoStar, a national real estate information company. Alan Whitson, Green Lease, Envtl. Design & Construction, July 17, 2006, available at www.edcmag.com/Archives/cc0c0b5ca1e7c010VgnVCM100000f932a8c0. This gives no financial incentive to tenants to conserve.

Proponents of the net lease say it creates a more transparent lease arrangement and an incentive for tenants to use less energy (because they may save directly in reduced operating costs as a result of individual reductions in use). In the reverse case, however, it also gives little incentive for the landlord to conserve common area costs if tenants are not individually metered (because the savings do not benefit the landlord), except to keep total rent within market ranges.

For decades, landlords have had an incentive to conserve and in fact have carried through on many types of energy saving initiatives, usually motivated by the desire to save energy costs and therefore make the building more competitive on a gross rent basis. Examples of this include re-glazing windows and double glazing single pane windows, upgrading the insulation and maintaining seals on building envelopes, undertaking lighting retrofits from inefficient lighting (perhaps with old PCB-based ballasts) to more efficient lighting and control systems, and undertaking retrofits of heating, ventilating, and air-conditioning systems and their controls to move to more energy-efficient systems.

Resistance to Green Leases

Many barriers discourage further efforts by landlords to make their buildings more energy, water, and resource efficient. These may include long payback periods for some types of improvements, indifferent or uncooperative tenants, the inability to pass through the current portion of landlord's amortized environmental capital costs, and a lack of skill or knowledge. Other barriers may include lack of knowledge of an achievable target by either the landlord or the tenant; lack of leadership, compulsion, or incentive from senior levels of government; lack of measurement systems in place to determine existing levels of water, natural gas, or electricity consumption; lack of capital; and lack of building operational expertise.

The existing lease documents within a portfolio are likely to contain many other restrictions. For example, landlord build-out specifications may apply to the tenant's premises, such as minimum foot candles of light at the desktop, tight permissible temperature ranges, limitations on landlord changes to the premises or base building features, or restrictions on the type of materials or equipment that can be used. There also may be an inability to pass through co-generation costs if provided by a third party, or an inability to pass through local utility standby costs if co-generation systems are used or proposed to be used.

Landlords, however, may not be the only ones interested in reducing their consumption of resources. What about commercial tenants who want to measure and reduce their energy and water consumption and increase recycling?

In many cases, large tenants are leading the way, requiring commercial landlords to make their buildings greener. Barriers to tenant efforts may include poor data from the landlord on premises-specific energy and water consumption, poor disclosure of energy use and the inability to compel different water-saving fixtures to be installed in common area washrooms. Energy and water costs may be shared also (for example, a single building meter allocated on a building-wide per square foot basis), which in the tenant's eyes would mean that there is no direct relationship between energy or water savings initiated by a specific tenant and the costs allocated to that tenant. A tenant's efforts to conserve would be shared by all occupants in the building, making all others "free riders."

Tenants may also be faced with indifferent or uncooperative landlords, or may fear an unfair rent increase if they ask for a "greener" building, because the current portion of water and energy-saving capital costs are possibly jammed through to the tenant on an unfair basis. Indeed, tenants may fear that the landlord will "green plate" the building at the tenants' cost (that is, to spend carelessly on green upgrades only because the cost can be 100% passed through to tenants). In some cases, tenants may need to get all tenants in the building together and form a group analogous to a "union" to persuade the landlord to green the building. This may be required to attain some leverage over the landlord or may be a mandated prerequisite by the landlord.

Tenants may also lack the skill or knowledge necessary to determine achievable targets for themselves or the building. They also may not have access to the required independent technical resources, or find the costs prohibitive, especially for small tenancies.

Last, restrictions in the lease may limit the ability of the tenant to go green. Examples include the requirement that the tenant use only new materials in all tenant improvements or that the tenant cannot alter base building features, common areas, or central systems. Other lease provisions may prevent the tenant from installing any equipment outside the leased premises; from requiring more recycling by the landlord; from compelling installation of bike racks on or adjacent to the ground floor of a building; and from installing on-site co-generating facilities such as solar voltaics. Other obstacles to a tenant's ability to go green are poor or no record keeping of individual tenant energy use, poor disclosure of energy use, and the inability to compel different water-saving fixtures to be installed in common area washrooms.

Defining a Green Lease

A "green lease" seeks to remove disincentives in a commercial lease to reduce energy, water, and raw material consumption; to increase recycling and the use of sustainable materials in tenant improvements; and to encourage sustainable practices by both the landlord and the tenant. A green lease works to ensure that tenants and landlords are required to adopt environmentally friendly practices.

What Is in a Green Lease?

There seem to be at least two approaches to a green lease:

a "paternalistic" approach, in which the obligations for reduced consumption and environmentally responsible behavior are mandated within the lease by either the tenant or the landlord; and

a "cooperative" model, in which mutual objectives are set out in the lease for both parties to achieve, leading to responsibilities and liabilities for both parties.

A tenant-paternalistic lease may be the case when government or a corporation with a strong green brand is a tenant, has internal "green" targets it is subject to, and wishes to force the landlord to do its part to assist in compliance. A landlord-paternalistic lease may be the case when a landlord wants to green its portfolio, or engage in carbon-trading, or be seen as environmentally responsible, and wants its tenants to toe the line to achieve certain environmental goals. A cooperative model lease may be the case when both parties buy into the need to green an existing building and want to ensure each is doing its part to achieve the joint goal. All three models may end up in the same place over time.

The following are some of the main elements of existing green leases:

Targets and Benchmarks—These include targets, expressed as either a percentage reduction or an absolute target in terms of objective measures (for example, kilowatts of energy and gallons/liters of water per square foot per year), for the environmental performance of the building for water and energy reduction, waste reduction, and waste and water recycling.

Ecologically Sustainable Development Principles and Regulations—These may include indoor air quality standards and rules governing the use of materials and the recycling of products.

Performance Standards—These may include specifications as well as procedures about how environmental performance is measured.

Dispute Resolution Mechanisms—These may apply in the event of a disagreement between the landlord and tenant over why a particular target or objective prescribed by the lease is not achieved. For example, this mechanism could outline the ramifications taken in the event that a tenant exceeds an energy use target or fails to comply with the environmental objectives set out in the lease.

Environmental Management Plan (EMP) and a GreenLease Schedule (GLS)—These components are commonly found in those green leases developed in Australia. An EMP is often featured within a GLS.

A green lease may specifically detail:

environmentally preferable products,

water conservation measures,

comprehensive landlord and tenant procurement guidelines,

energy conservation/efficiency targets,

requirements for natural or low water consumption landscaping,

the permissibility of solar or wind applications on-site,

the ability to specify higher cost but sustainable energy sources,

indoor air quality standards,

construction period recycling,

life-cycle costing,

day lighting and the usage of screens to shield the sun's rays,

recycling room and practices,

efficient appliances and fittings,

waterless urinals and low-flow faucets and taps,

efficient thermal control systems and potentially operable windows,

the use of EnergyStar-rated photocopiers that reuse paper or print double-sided,

an energy or operations standard, such as LEED, Green Globes, BREEAM, AGBR, Energy Star, or other rating system,

To the extent that the parties believe that technical goals need to be defined in a lease document or schedule (such as target kilowatts per square foot per year or reduced water consumption to a target of liters/gallons per square foot per year) then the landlord, tenant, or both may need technical consultants available to them to advise on the legitimacy and attainability of those technical goals in the particular building to which the green lease would apply. The same technical expertise would also need to be available to determine compliance or to provide audits from time to time potentially for both parties.

Green leases may be considered as "partnerships" or "alliances" requiring greater cooperation between landlord and tenant than traditional leases. It is also important to mention that poor performance within any particular tenancy may affect comfort and performance in other tenancies in a multi-tenant building. The underlying notion is that what one tenant does or does not do could ultimately affect other tenants in the same building.

Conclusions and Recommendations

Commercial buildings are significant consumers of electricity and water, and generate significant waste. When the source of electrical power is coal or natural gas, the need to reduce energy consumption, and thereby reduce greenhouse gas emissions, is critical. Water conservation is just as important, and landlords need to be increasingly conscious of water conservation in new building designs and existing building management. Similarly, too much solid waste is produced by commercial buildings. Many commercial landlords provide "blue bins" to recycle paper waste, but there is little commercial separation of cans, bottles, and organic waste at the source. LEED and other rating systems encourage efficient building design, recycling of construction materials when possible, and the use of local materials when not.

Lawyers are on the front lines of lease negotiation and can lead change. Of course, brokers, owners, and tenants all need to be committed as well. Current commercial leases are a barrier to achieving significant reductions in greenhouse gas production, water and energy consumption, and material use. Given that they are long-lived documents, efforts to modify base form leases to make them green should be undertaken now. Given the re-education program that all market participants will need to prioritize and price green initiatives on a building-by-building basis, to agree on objectives and targets, and to understand new green lease standards, more green lease development, leadership, and innovation is needed from real estate lawyers and other real estate leaders. That leadership is required now.